Fortunately We Learn From The Past…. (or not!)

By Filipe R. Costa

The financial crisis of 2007-2008 was one of the worst economic catastrophes of the last few decades. It laid low household names, such as Lehman Brothers and Washington Mutual, left many Americans with work and homes, tore away half of the S&P500’s value and dragged down much of the world with it.

Although there are many explanations how this calamity came to pass, there’s little doubt that some of the key contributory factors were the financial industry’s lax attitudes towards risk, its lack of ethics, careless due diligence and poor decisions. These all helped create a bubble, which had to burst sooner or later. Credit fuelled housing prices could not carry on going up indefinitely, even through the industry built its model around this fantasy vision.

When the bubble popped, valuations fell off a cliff.

To ward off an imminent, total collapse, the US government had to bail out several financial institutions (with taxpayers’ money of course!) and the Federal Reserve provided an incredible amount of emergency liquidity. Trillions of dollars were spent in the process!

Five years later and the official line is that we can say that the worst of the crisis is behind our backs and lessons have apparently been learned. But five years after the storm, demand is coming back for highly leveraged loans and we have just heard this has pushed “covenant-lite” lending to a record $188.7billion. This surpasses the record set in 2007.  

Covenant-lite or covenant-light loans are unsecured. This type of loan is used by creditworthy companies, which are usually strong and have low leverage. The lack of covenants makes it easier to set the terms of the loan and for the borrower to pay it back. When credit quality isn’t an issue, these loans are a good way to raise money and have almost no risk for investors. The problem is that these loans are now being backed by a multitude of investors and are being issued by much smaller companies, with doubtful credit rating. Investors, concerned with the potential rise of interest rates, started looking for floating rate loans in earnest in May. Judging by the sudden growth of these loan types, it’s like everything is AAA again.

Sound like deja-vu? Backing all debt as if it were all high quality?

If the trend continues, there will be a point when someone will revalue these loans and come to the obvious conclusion they’re worth less than thought initially.

If this all sounds eerily familiar, it’s because it is. We’ve been here before and it looks like yet another credit bubble is forming.

It’s interesting to hear/read the Fed’s Jimmy Bullard talk about bubbles. According to him, he believes there’s no bubble going on or forming. Even more interesting is his justification. He believes the reason there’s no bubble is that both the tech and housing bubbles were “no secret”. “Bubbles of the past were gigantic and obvious…not now”.  So, everybody saw the bubbles in the past and now there’s no bubble because nobody sees one. Am I the only one who thinks this is backwards logic?!

At the same time, if we take his words seriously, then we must come to one of two possible conclusions about the past: 1) as everybody saw the bubble but nothing was done by the Fed, then the Fed was the only organisation not to see it or; 2) the Fed saw the bubble but did nothing to deflate it in a controlled manner.

Draw your own conclusions as to which scenario seems more likely but, we have to ask -just whose interests are the Fed looking after?!